LAW EXTENSION COMMITTEE INSOLVENCY LECTURE 3 LAW EXTENSION COMMITTEE

DUTIES OF DIRECTORS - AT COMMON LAW Directors owe duties to their companies because they are fiduciaries in relation to the company. At common law they owe duties of good faith and duties of care and skill. At common law the duty of good faith includes the following duties: to act honestly in the best interests of the company; to exercise powers for a proper purpose; to act with an unfettered discretion.

DUTIES OF DIRECTORS - BY STATUTE By the Corporations Act directors owe four kinds of statutory duties: to exercise reasonable care - Section 180; to act in good faith in the best interests of the corporation and for a proper purpose - Section 181; not to make improper use of their position to gain an advantage - Section 182; not to make improper use of inside information to gain an advantage - Section 183.

LIABILITY OF DIRECTORS A director may be liable in damages to the company for breach of duty. A director may also be liable to a civil penalty order of up to $200,000 on the application of ASIC - Section 1317E, 1317G. A director may be subject to separate civil action for recovery of profits or compensation from the liquidator - Section 1317J(2). ASIC may also seek an order that the director be disqualified from being a company director for a period - Section 206C. A court may relieve a director from civil liability under Section 1317H where the director is judged to have acted honestly and ought fairly to be excused - Section 1317S.

LIABILITY OF DIRECTORS The court will take into account the actions of the director in the case of an insolvent company. Officers who breach any of Sections 180-183 may also be criminally liable if guilty of recklessness or intentional dishonesty - Section 184. The directors owe a duty to take into account the interests of creditors where the company is insolvent or facing insolvency. The directors may be liable if they have done anything to reduce the entitlements of employees, in the event of insolvency - Section 596AC.

SHADOW DIRECTORS A “Shadow Director” under the definition (b)(ii) in Section 9 of the Corporations Act is a person in accordance with whose instructions or wishes the Directors of a Company are accustomed to act. The instructions or wishes must be in relation to Board activities and not just managerial decisions. The ultimate question is – who is effectively making Board decisions? “Accustomed” means a pattern of compliance over a period of time.

SHADOW DIRECTORS The Court of Appeal set out five propositions in Buzzle Operations Pty Limited (In Liquidation) v Apple Computer Australia Pty Limited [2011] NSWCA 109: Not every person whose advice is heeded as a general rule by the Board is to be classed as a Shadow Director If a person has a genuine interest of his or her own in giving advice to the Board (such as a bank or mortgagee) the mere fact that the Board will tend to take that advice to preserve it from the mortgagee’s wrath will not make the mortgagee a Shadow Director The vital factor is that the Shadow Director has the potential to control But the evidence must show something more than just being in a position of control. The facts must show that the power to control was put into practice. Where a Board splits into a majority and a minority faction, so long as the influence controls the real decision makers, the person providing the influence may be a Shadow Director.

INSOLVENT TRADING Part 5.7B Corporations Act The liquidator can recover from directors any losses suffered by creditors, if they have permitted their company to trade while insolvent - s 588G and s 588M(2). S 588G(2) is also a civil penalty provision enforceable by ASIC - directors can be liable to a pecuniary penalty, a disqualification order and a compensation order. The directors owe a duty to take into account the interests of creditors where the company is insolvent or facing insolvency. The directors may be liable if they have done anything to reduce the entitlements of employees, in the event of insolvency - Section 596AC.

Edwards v ASIC [2009] NSWCA 424 INSOLVENT TRADING The statutory purpose of the insolvent trading law is : to discourage and provide a remedy for a particular types of commercial dishonesty or irresponsibility when a company which is at or approaching insolvency obtains a loan, property or services on credit and either a director knows or suspects insolvency or a reasonable person in the director’s position would know or suspect it Edwards v ASIC [2009] NSWCA 424

INSOLVENT TRADING Section 588G provides for directors to be liable for insolvent trading if the following criteria apply: they are directors when the company incurs a debt; the company was insolvent at the time when the debt was incurred or became insolvent as a result of the incurring of the debt; there were reasonable grounds for suspecting that the company was insolvent or would become insolvent as a result of the debt being incurred; and the directors were aware that there are reasonable grounds for suspecting the company was insolvent OR a reasonable person in a like position in a company in the company’s circumstances would be so aware.

INSOLVENT TRADING “Indicators of insolvency” : 1. Continuing losses. 2. Liquidity ratios below 1. 3. Overdue Commonwealth and State taxes. 4. Poor relationship with present Bank, including inability to borrow further funds. 5. No access to alternative finance. 6. Inability to raise further equity capital. 7. Suppliers placing company on COD, or otherwise demanding special payments before resuming supply. 8. Creditors unpaid outside trading terms. 9. Issuing of post-dated cheques. 10. Dishonoured cheques.

INSOLVENT TRADING “Indicators of insolvency” : 11. Special arrangements with selected creditors. 12. Solicitors' letters, summonses, judgments or warrants issued against the company. 13. Payments to creditors of rounded sums which are not reconcilable to specific invoices. 14. Inability to produce timely and accurate financial information to display the company's trading performance and financial position, and make reliable forecasts.” - ASIC v Plymin [2003] VSC 123.

INSOLVENT TRADING Test for insolvency: s 95A Corporations Act - unable to pay all debts as and when they become due and payable Sandell v Porter 115 CLR 666 at 670 The “cashflow test” A recent case example : McLellan, in the matter of The Stake Man Pty Ltd [2009] FCA 1415 - see the article in (2010) 18 Insolv LJ 96

“DEFENCES” There are four alternative defences in Section 588H. A director must prove one of the following: that when the debt was incurred the director had reasonable grounds to expect that the company was solvent and would remain solvent even if the debt was incurred; that when the debt was incurred the director had reasonable grounds to believe, and did believe, that a subordinate was competent, reliable and responsible for providing adequate information about the company’s solvency and the director expected, on the basis of this information that the company was solvent and would remain solvent; that when the debt was incurred the director, because of illness or for some other good reason, did not take part in the management of the company at that time; or that the director took all reasonable steps to stop the company from incurring the debt.

“DEFENCES” “There comes a point where the reasonable director must inform himself or herself as fully as possible of all relevant facts and then ask himself or herself and the other directors: ‘How sure are we that this asset can be turned into cash to pay all our debts, present and to be incurred, within three months? Is that outcome certain, probable, more likely than not, possible, possible with a bit of luck, possible with a lot of luck, remote, or is there is no real way of knowing?’ If the honest and reasonable answer is “certain” or “probable”, the director can have a reasonable expectation of solvency. If the honest and reasonable answer is anywhere from “possible” to “no way of knowing”, the director can have no reasonable expectation of solvency. If the honest and reasonable answer is “more likely than not”, the director runs the risk that a Court will hold to the contrary in an insolvent trading claim.” Hall v Poolman [2007] NSWSC 1330 per Palmer J

FORGIVENESS Sections 1317S and 1318 give the court power to excuse a director from liability if : the director has acted honestly; and having regard to all the circumstances of the case, the director ought fairly to be excused from the contravention. The sections reflect a broad legislative policy that insolvent trading may be excused if it was a result of honest error or inadvertence and where the court can avoid its effects without prejudice to third parties or to the public interest in compliance with the law - (2010) 18 Insolv LJ 96.

FORGIVENESS “In my view, when considering whether a person has acted honestly for the purposes of a defence under ss 1317S(2)(b)(i) or 1318 of the CA, the court should be concerned only with the question whether the person has acted honestly in the ordinary meaning of that term, that is, whether the person has acted without deceit or conscious impropriety, without intent to gain improper benefit or advantage for himself, herself or for another, and without carelessness or imprudence to such a degree as to demonstrate that no genuine attempt at all has been made to carry out the duties and obligations of his or her office imposed by the Corporations Act or the general law. A failure to consider the interests of the company as a whole, or more particularly the interests of creditors, may be of such a high degree as to demonstrate failure to act honestly in this sense. However, if failure to consider the interests of the company as a whole, including the interests of its creditors, does not rise to such a high degree but is the result of error of judgment, no finding of failure to act honestly should be made, but the failure must be taken into account as one of the circumstances of the case to which the court must have regard under ss 1317S(2)(b)(ii) and 1318 of the CA.” - Hall v Poolman [2007] NSCSW 1330 at [325] per Palmer J

FORGIVENESS Case example : The Stake Man The director did not profit personally He did not disregard advice from a financial adviser in allowing the company to trade Forgiveness is available even though a statutory defence cannot be made out. This is the first case where a director has been completely exonerated (in Hall v Poolman, there was partial exoneration).

FORGIVENESS To maximise the chances of judicial forgiveness: The directors must be diligent The directors must understand the company’s business The directors must pay attention to the company’s financial affairs The directors must be pro-active in seeking and relying on professional advice see (2010) 18 Insolv LJ 96 at 102

ASIC GUIDE See ASIC Regulatory Guide 217 (in Course Notes): Directors must remain informed Directors should investigate financial difficulties Directors should obtain advice Directors should act in a timely manner

CONSEQUENCES OF LIABILITY FOR INSOLVENT TRADING The director may be the subject of a pecuniary penalty application by ASIC, or a compensation order sought by ASIC on behalf of the creditors. The director may be sued by a liquidator if the debt was unsecured and a creditor suffered loss - Section 588M. Individual creditors cannot sue the director without the consent of the liquidator - Section 588R. The proceeds of a successful insolvent trading claim by a liquidator are available for the benefit of the creditors, except any creditors who knew of the company’s insolvency - Section 588Y. Most of the insolvent trading cases which are commenced are settled.

CRIMINAL OFFENCES If ASIC believes that a criminal offence has been committed it may prosecute - Section 1315. Breaches that are minor may be dealt with by way of a penalty notice - Section 1313. Prosecutions may be also brought for breaches of State or Commonwealth Crimes Legislation, as well as breaches of the Corporations Act. There are a number of prescribed offences in relation to liquidation - Section 590. Criminal proceedings are only brought for offences linked to fraud or dishonesty. They carry penalties of imprisonment for up to 5 years

WHO FUNDS INSOLVENT TRADING CLAIMS ? The liquidator – but only if the company has sufficient assets Creditors who volunteer to do so (and who become priority creditors for their costs) (More and more frequently) litigation funders

LITIGATION FUNDING For a long time it was not permissible for a third person, unconnected with a piece of litigation, to provide funding for that litigation on the basis that the third person would receive a share of the fruits of the action. It was said that this was against public policy and was an abuse of process. It was even a tort – champerty or maintenance.

LITIGATION FUNDING Over the last 20 years litigation funding has developed to assist parties with the costs of litigation. Litigation funding involves a commercial entity agreeing to pay the costs of the litigation (including any adverse costs orders) in return for a share of any recoveries if that litigation is successful. The litigation funder is not one of the parties to the litigation and apart from an interest in the financial outcome, has no interest in the subject matter of the proceedings.

LITIGATION FUNDING The High Court has held that litigation funding is not an abuse of process and is, subject to certain restrictions, an acceptable practice. In Campbells Cash & Carry Pty Limited v Fostif Pty Limited [2006] HCA 41 a litigant commenced proceedings in the Supreme Court of NSW seeking recover of tobacco licence fees. The proceedings were commenced with the assistance of a litigation funder who was to receive a “success fee” of one-third of any amount recovered by the plaintiff retailer. The trial judge found that the litigation funding arrangements were against public policy and constituted an abuse of process. That decision was reversed on appeal to the NSW Court of Appeal. The appellant was granted special leave to appeal to the High Court of Australia.

LITIGATION FUNDING The majority of the High Court held that none of the elements of the litigation funding arrangement proposed by the litigation funder, such as: the litigation funder’s motive of profiting from the litigation of others; the litigation funder seeking out or encouraging persons to sue when they would otherwise not have done so; the potential profits to be made by the litigation funder; or the litigation funder’s control of the proceedings, either alone or in combination, required condemnation as being contrary to public policy or leading to any abuse of process.

LITIGATION FUNDING In July 2012 the Federal Government enacted regulations that excluded funded class actions from the definition of “managed investment schemes” and exempted the funding of class actions from the requirement to hold an Australian Financial Services Licence. These steps were necessary as the Federal Court had held that the funding arrangements in a shareholder class action constituted a managed investment scheme: Brookfield Multiplex Limited v International Litigation Partners Pte Limited [2009] FCAFC 147

LITIGATION FUNDING In October 2012 the High Court held that litigation funders do not require an Australian Financial Services Licence because funding arrangements are “credit facilities” and the Corporations Act 2001 provides that a “credit facility” is not a “financial product” : International Litigation Partners Pte v Chameleon Mining NL [2012] HCA 45

LITIGATION FUNDING ASIC has recently issued new guidelines warning about conflicts of interest between law firms and litigation funders in an effort to better protect people who take part in major litigation, such as class actions. This followed the revelation that a plaintiff’s law firm and its principals had financial ties to a litigation funder which the firm proposed to use for a class action. The new ASIC guidelines will force funders to manage and disclose potential conflicts to better protect litigants: ASIC Report 338, April 2013, “Response to Submissions CP 185 Litigation Schemes and Proof of Debt Schemes: Managing Conflicts of Interest”

PAST EXAM QUESTION ON INSOLVENT TRADING Question 1 from September 2014 Kilgore Pty Limited (“Kilgore”) has been making surfboards for many years but its designs are now seen as old-fashioned. Kilgore is essentially a two-person company. Steve Kilgore is the managing director who makes all the decisions, and Mary Kilgore, his spouse, is a “silent” director who takes no part in the running of the business. She does not attend meetings but her name is put on the minutes anyway. Kilgore falls behind in paying suppliers of materials. By agreement with the workforce, it delays wages payments to its employees. It approaches its bank, but the bank declines to lend more money. Kilgore engages a business adviser who recommends cutting its product range, sacking staff and borrowing money offshore. Steve follows this advice and obtains an additional $500,000 loan that is unsecured. Unfortunately the attempt to revitalize the company fails and Kilgore goes into liquidation. The liquidator contemplates an action against Steve and Mary for insolvent trading. Advise the liquidator what he will have to prove, and what defences might be raised.